Mutual Funds: The Five Things You Need to Know

If you are looking to diversify your investments, a mutual fund could be an easy solution.

Mutual funds can offer built-in diversification and professional management, which could be a benefit for an investor that isn’t comfortable buying individual stocks and bonds. They are also easy to buy and sell, though unlike stocks or exchange-traded funds, mutual funds are generally priced only once a day.

There are literally thousands of mutual funds out there ranging from stock funds or bond funds, to balanced funds that invest in both of those asset classes. There are also money market funds, which invest in very short-term investments, such as 3-month Treasury bills.

But not all mutual funds are created equal, and like any security, investing in mutual funds involves risk. Funds can vary in their investment strategy, risk profile, performance history, management and fees.

Here are five things you need to know before you invest in mutual funds.

1. What is a mutual fund?

A mutual fund is an investment company that pools money from many investors and invests it based on specific investment goals. The mutual fund raises money by selling its own shares to investors. The money is used to purchase a portfolio of stocks, bonds, short-term money-market instruments, other securities or assets, or some combination of these investments.

Each share represents an ownership slice of the fund and gives the investor a proportional right, based on the number of shares he or she owns, to income and capital gains that the fund generates from its investments.

The particular investments a fund makes are determined by its objectives and, in the case of actively-managed funds, by the investment style and skill of the fund's professional manager or managers. The holdings of the mutual fund are known as its underlying investments, and the performance of those investments, minus fund fees, determines the fund's investment return.

2. What is the fund’s goal?

Each mutual fund has a specific investment strategy or goal. The particular investments a fund makes are guided by that objective.

While there are literally thousands of individual mutual funds, there are only a handful of major fund categories:

  • Stock funds, which invest largely in stocks
  • Bond funds, which invest largely in bonds
  • Balanced funds, which invest in a generally predetermined mix of stocks and bonds
  • Money market funds, which invest in very short-term investments and are sometimes described as cash equivalents
  • Funds of funds, which invest in other mutual funds
  • Target-date funds, funds of funds that change their investment mix over time

You can find all of the details about a mutual fund — including its investment strategy, risk profile, performance history, management, and fees — in a document called the prospectus. You should always read the prospectus before investing in any fund.

3. How much is this going to cost me?

All mutual funds charge fees. A small percentage difference in fees can add up to a big dollar difference in the returns on your mutual fund, so it is important to be aware of all the fees associated with any fund you invest in.

Some fees are charged at specific times, based on actions you take, and some are charged on an ongoing basis. You can compare the fees and expenses of different funds, or among different share classes of the same fund, using FINRA’s Fund Analyzer.

Generally, mutual funds will have a higher fee if it is actively managed and a lower one if it is simply benchmarked against a certain index, which leads us to our next question.

4. Is it actively or passively managed?

When a fund is actively managed, it employs a professional portfolio manager, or team of managers, to decide which underlying investments to choose for its portfolio. The goal of an active fund manager is to "beat the market," that is, to get better returns than the unmanaged index or benchmark that most closely relates to the fund’s investment strategy. For instance, many large-cap stock funds typically use the Standard & Poor's 500 Index as the benchmark for their performance.

One of the challenges that portfolio managers face in providing stronger-than-benchmark returns is that their funds' performance needs to compensate for their operating costs — the cost of hiring the professional fund manager and the cost of buying and selling investments in the fund. To beat that benchmark, an actively managed fund would need to generate returns that make up for, and exceed, that extra cost.

In any given year, most actively managed funds do not beat the market. Last year, 86% of active funds missed the mark, according to an S&P Dow Jones Indices scorecard released in March. That's why many individuals invest in passive funds, which don't try to beat the market at all. Passive funds, or index funds, seek to replicate the performance of their benchmarks instead of outperforming them.

For example, an index fund that tracks the performance of the S&P 500 would typically buy a portfolio that includes all of the stocks in that index in the same proportions as they are represented in the index. If the S&P 500 were to drop a company from the list, the fund would sell it, and if the S&P 500 were to add a company, the fund would buy it.

Passive funds typically have lower operating costs, because they don’t need to retain active professional managers to pick and choose stocks.

5. How diversified is it?

If you buy a single stock or bond, you're putting all your eggs in that one basket. Just by virtue of being a pooled investment, a mutual fund can give you exposure to a number of stocks, bonds, short-term money-market instruments, other securities or assets, or some combination of these investments.

But remember: If the fund has a very narrow focus — investing only in tech stocks, for example, or in securities issued by companies from a single foreign country — then you might not be all that diversified.

As you research mutual funds, keep in mind that a mutual fund is only required to invest at least 80 percent of its assets in the type of investment suggested by its name. That means it can invest up to one-fifth of their holdings in other types of securities — including securities that you might consider too risky or perhaps not aggressive enough.

You can check a fund’s latest quarterly report to see how closely the fund manager is sticking to the strategy described in the prospectus.